Optimism is still in very short supply

Both of these measures of consumer confidence (Conference Board on top, Michigan on the bottom) are saying the same thing: confidence has improved from the abysmally low levels of the past recession, but confidence is still very low from an historical perspective. I think the same can be said for the equity market, where flows into domestic equity funds remain decidedly negative.

So I continue to believe that the rally in equity prices is not being driven by optimism. It is being driven by a reduction in pessimism. It's not that the economy is doing great, it's that the economy is not doing as badly as the market has been expecting.

Corporate profits continue to impress

Today's release of fourth quarter GDP revisions showed little change, but it did provide us with the first look at corporate profits for the quarter. After-tax corporate profits rose 8.5% last year to $1.58 trillion on a seasonally adjusted annual basis. As the charts above show, this was a record both in nominal terms and relative to GDP; in fact, corporate profits have been breaking both these records since the fourth quarter of 2009.

Ordinarily, you would think that 9 consecutive quarters of record-setting corporate profits would be cause for great celebration on Wall Street, with jubilant investors sending PE ratios to the moon, but you would be dead wrong. Instead, the PE ratio of the S&P 500 today stands at 14.4, well below its 50-year average of 16.6, and down sharply from its Q4/09 average of 21. What does this mean? It's simple: investors don't believe corporate profits can continue to rise, having already wildly exceeded previous highs relative to GDP. Indeed, I would argue that the stock market is priced to the expectation that corporate profits are likely to decline significantly, both in nominal terms and relative to GDP. Call it a mean-reversion expectation: profits, according to the market's logic, should sooner or later return to their long-term average of just over 6% of GDP, and perhaps fall even further—there's no way they can remain this high.

I think this is a pretty pessimistic outlook, but no matter what adjective you use to describe the market's expectations, it would not be anything like optimistic.

This chart of U.S. corporate profits (the same profits used in the other charts above) relative to global GDP puts the issue in a whole new light. Suddenly, profits are not usually high at all. Why the huge difference? U.S. corporations have been busy globalizing in recent decades, and the global economy has been growing much faster than the U.S. economy. U.S. corporations now address a global market that has grown by leaps and bounds, and profits as a share of global GDP are about average. It no longer makes sense to look at corporate profits as a share of U.S. GDP. Anyone who today can sell his products and services to the world has the ability to make profits that were inconceivable just a few decades ago. For starters, think Apple, Hollywood, and Qualcomm: Apple is now a major player in the gigantic Chinese mobile phone market; Hollywood films are watched by billions of eyeballs; and Qualcomm chips are in the vast majority of smartphones, the fastest growing segment of the global mobile phone market. In short, the rationale for expecting a significant deterioration in corporate profits that seems to have infected the equity market is not compelling at all.

And that means that you don't have to be a wild-eyed optimist to like today's equity valuations. Even if you don't think that U.S. growth is going to pick up in any meaningful fashion for a long time, profits could continue to impress.

Unemployment claims continue to decline

At first glance, weekly claims for unemployment came in higher than expected, but that was entirely due to revisions to seasonal adjustment factors. After the revisions, claims fell to their lowest level in several years. On an unadjusted basis, claims are down 10.5% from year-ago levels and have been on a clear downtrend since April 2009. No news here, it's steady as she goes: fewer and fewer workers are being laid off, and this is a good sign that the economy has undergone a lot of painful adjustments and is thus healing itself from within. It's all part of the natural recovery forces which I discussed in yesterday's post.

The natural forces of recovery

Fiscal and monetary policy get all the attention these days when discussing the economy's recovery or lack thereof, but they are only a part of the recovery story.

What has driven the recovery to date is the hundreds of millions of decisions made by businesses and workers as they struggle to adjust to a reality that was not what they expected.

Businesses have cut staff in order to reduce costs. Some have relocated or shut down. Some have sold assets for a loss, thus allowing another business to redeploy those assets in a new, more profitable venture. Some have created new products; some have figured out how to make their products better or more cheaply. Some entrepreneurs have taken a risk and started a new business. Some have paid down debt, others have taken on new debt. Some have increased hiring. Some have discovered new ways of finding and producing natural gas while risking their fortunes in the process.

Workers have relocated to find a new or better job elsewhere. Many have decided to work harder or longer hours. Many have tightened their belts and cut back on their expenses. Many have decided to start their own business, or to work part-time, or to accept a pay cut. Many have learned new skills, or taken a job in a different field.

These are the things that make the economy bigger, stronger, more efficient, and more productive; that raise living standards, that create new jobs. Labor and capital need to make millions of adjustments in the wake of a recession, and in response to unexpected shocks. All that fiscal and monetary policy can do is to facilitate those decisions and those painful adjustments.

Unfortunately, fiscal policy has not been helpful in this regard. Extending unemployment benefits only delays workers' decisions to work harder or learn a new job or accept a pay cut or relocate. Transfer payments reward those who are not working while penalizing those who are; they do nothing to create new jobs. New regulations make it more difficult to start new businesses. The prospect of huge new tax burdens resulting from trillion-dollar deficits reduces the incentive for entrepreneurs to take new risks and start new companies and hire new workers. Increased government spending only saps the economy's limited resources. The uncertainty surrounding the expiration of the Bush tax cuts at the end of this year is a concern for businesses deciding what to do with their profits, and it is a concern for investors wondering whether they should take their profits now, and whether higher taxes will crush the market next year.

Monetary policy has also been a problem. With the Fed and many other central banks now navigating in the uncharted waters of massive quantitative easing, markets are consumed with uncertainty about the future value of currencies, and many investors have sought out gold and commodities for that reason. Zero interest rates have left retired people with a huge shortfall of income relative to what they had expected. A weak dollar has prompted many central banks to buy massive amounts of dollars in order to keep their currencies from appreciating against the dollar, and Treasuries are about the only dollar asset they can buy, and that in turn has contributed to depressing yields.

Lots of adjustments, and lots of problems remaining. But the net result of everything has been an economy that has been expanding, albeit slowly, for almost three years, while creating almost 4 million new jobs in the process. There's still a long ways to go before things return to normal, but we are making progress, thanks to the untold millions of difficult decisions made every day by hundreds of millions of managers, investors, workers, and consumers.

Growth is not made in Washington. Growth happens in the heartland, and it is mainly driven by people who are trying to put food on the table and create a better life for themselves and their families. This is the force that has given us a recovery, and I believe it is an enduring force; it is the unique and dynamic nature of the U.S. economy that should never be underestimated.

Argentina, the land of deja-vu all over again

This is a follow-up to a post from last October, in which I discussed how the massive devaluation of the Argentine peso in early 2002 has translated almost one-for-one into higher inflation, very much as monetary theory would predict. I also mentioned how the government has been trying in vain to "suppress" inflation by gaming the CPI (first chart above).

Five months later, the story is the same, only now things are starting to get worse. As the second chart shows, true inflation is now double the "official" rate shown in the first chart. Since the peso was first pegged at 1:1 to the dollar in 1993, the price of a dollar has gone up by a factor of 4.4, and the price level (as measured by the GDP deflator) has gone up by a factor of 4.2. Confidence in the economy and the government is declining; the government has tapped the central bank's reserves to make payments on its international debt; in order to arrest capital flight which was also draining the central bank's reserves, the government has imposed exchange controls and restrictions on imports (many of which are not being granted, thus threatening to shut down the economy); and predictably, the exchange controls and import restrictions have led to the emergence of a "black market" for dollars.

I have been following developments in Argentina closely for the past 40 years, and I have lost track of the number of times that the government has meddled with the economy in ways which inevitably lead to inflation, devaluation, and economic collapse. I've seen this movie so many times it's like watching a slow-motion train wreck. The gap between the black market and the official exchange rate (now 5.25 and 4.4, respectively) will widen, more capital will leave the country, new investments will slow to a crawl, the economy will slump, and the government will eventually engineer one more in a long line of major devaluations. This in turn will provoke an inflationary recession and impoverish the private sector (the purpose of devaluations for countries like Argentina is to transfer wealth from the private to the public sector). As the dust settles, capital will begin trickling back in, import and exchange controls will be lifted, and the economy will slowly get back on its feet, but only at great cost in lost output and lower living standards for nearly everyone. It's a tragedy that has played out dozens of times in the past 40-50 years, but politicians never seem to learn, always thinking that they can outsmart the market—and line their pockets in the process.

Argentina is living proof that capital only resides in countries where it is respected and allowed to move freely. If capital is not free to leave, exchange controls only create a huge incentive for resourceful citizens and companies to skirt the controls and move money offshore, while destroying confidence and investment in the process. Unless President Kirchner comes to her senses quickly, which I doubt, the economy is doomed to suffer yet another painful recession.

We'll be spending a few weeks in Argentina next month, so I'll have the "privilege," that only an economist can enjoy, of watching how declining demand for pesos leads to higher prices even as the economy declines. The last time I saw this happen, prices almost tripled in the space of three weeks; I hope it won't be so bad this time.

Natural gas is becoming incredibly cheap

Forget the collapse of the housing market, this is much bigger news. It's the most dramatic change that is happening beneath the surface of the U.S. economy today. As the rest of the world struggles with oil prices that are very expensive both nominally and in real terms (see chart below), the U.S., thanks to new tracking technology, is enjoying the fact that natural gas prices are plunging. Even as crude oil prices have surged over the past 13 years from $12/bbl to over $100, the price of natural gas in the U.S. is roughly unchanged on net. That means (as the second chart above shows) that natural gas has dropped by an astounding 85% relative to crude oil. We've never seen anything like this. The U.S. now enjoys an incredible energy price advantage that not only is transforming industries (for example, it shouldn't be too long before we start seeing cars that run on LNG), but that should be an important source of growth for the entire economy. This could be the best reason to be bullish.

Home prices decline but the future is looking bright

According to both Case Shiller and Radar Logic, U.S. housing prices were still declining late last year and early this year (both series report prices with a considerable lag). Nominal prices have fallen by one-third, while real prices have fallen by 41% since their mid-2006 highs. Ouch.

This all sounds pretty grim, but not when contrasted with news today that bidding wars are breaking out in Seattle, Silicon Vally, Miami, and Washington. To sum up the current state of the housing market, we are in the midst of an important inflection point in which prices are no longer uniformly declining but in some areas prices are now rising. Focusing on where housing prices were several months ago is missing the larger picture, which is that we have seen the worst of the housing debacle and the future is looking brighter. Obsessing over the historically miserable 700K pace of housing starts is to miss the more important fact that starts are up 35% in the past year.

The stock market figured this out long ago. Homebuilders' stocks are up 160% from their recession lows; and REITS have returned 240% since the market bottomed in early March 2009, about double the 123% total return on the S&P 500. In short, housing prices are a terribly misleading picture of the dynamic that has been playing out in the market for the past several years. Prices are way down, to be sure, but that is the way the market deals with an excess inventory of housing. Housing prices are now incredibly affordable, and the excess inventory has been completely worked off in at least several markets around the country. It won't be long before bidding wars start erupting in nearly every market, and when the news of rising home prices finally makes the headlines, there could be a buying stampede.

UPDATE: Add Phoenix to the list of cities with rising home prices. HT: Chris Lee

Bernanke is being way too cautious

Fed Chairman Bernanke's remarks today were designed to justify the continuation of ultra-accommodative monetary policy. To be sure, the economy is suffering from a huge "output gap," but nevertheless, there are plenty of signs that things are improving on the margin.

The economy is definitely creating new jobs, and it's even possible that jobs are growing at an accelerating pace, as suggested by the household survey of private sector employment in the chart above. The economy is likely still well below where it should be, but if current trends continue there will be a full jobs recovery within a year or so. We don't need cheap money to make that happen, we just need to let the natural forces of recovery and growth do their thing. The profit motive is a powerful source of growth, and left to their own devices entrepreneurs and workers will expend lots of effort to figure out how to work harder and more efficiently.

One of the big reasons the last recession was so deep and protracted was that the market's fear of a global financial collapse and depression reached extremely high levels. It's taken three years to slowly and gradually erase these fears, and both the equity market and the economy have responded rationally to the reduction of perceived risk by growing.

Equities have also tracked the behavior of unemployment claims. Claims are a good proxy for the degree to which the economy has to make painful adjustments. The economy had to shift massive amounts of resources away from the residential construction and banking industries into other areas. With claims now close to returning to "normal" levels, it's not unreasonable to think that most of this painful adjustment process has been completed. Going forward the economy is going to do more of what comes naturally—grow—rather than slash and burn. Fear has returned to more normal levels, and most of the painful adjustments to new economic realities have been completed, so it is not surprising that equities have recovered much of the ground that they lost .

What's still lacking, however, is confidence in the future. As this chart shows, Treasury yields are extremely low, and have only responded weakly so far to signs of improvement in the economy. When I see 10-yr Treasury yields at or near 2% I can't help but think that the market holds out almost no hope of any meaningful economic growth in the years to come. I think Bernanke's repeated expressions of concern, and the Fed's continued willingness to pull out all the monetary stops in order to goose the economy, are contributing to the market's pessimistic outlook.

Investors are still shell-shocked from the events of a few years ago, so they have little problem believing that if it weren't for ultra-accommodative monetary policy and massive fiscal deficits, the economy would sure enough slip back into a recession. Investors think the economy is on life-support, whereas to me it looks like the economy is recovering in spite of all the ministrations of Washington.

Should we return to a gold standard?

Ralph Benko and Charles Kadlec, both long-time supply-siders (even longer than me), recently published a nice booklet, The 21st Century Gold Standard," that can be downloaded for free at the link. It covers gold standards throughout history and how and why they have been successful in maintaining a constant purchasing power for currencies, and it makes a strong case for returning to a gold standard today. The authors back up their arguments with solid reasoning and plenty of facts, and they convincingly counter all the standard arguments against a gold standard. The booklet is short, well-written, eminently sensible, and accessible to everyone. If you've ever wanted to know more about how and why a gold standard is the best hope for a stable currency and a strong and prosperous economy, this booklet is for you.

One important detail about returning to a gold standard gets only a brief mention in the book: at what gold price should the dollar once again be tied to gold? The authors say only that "one of the key principles for the transition to a gold standard is to allow a market price discovery period to ensure, with complete confidence, that the current price level is maintained and there is no downward pressure on wages." That's important, because if the dollar is pegged to a gold price that is too high, then it will lead to inflation, while pegging to a gold price that is too low would lead to deflation. How to find the right gold price might well be the most difficult and critical part of transitioning to a new gold standard. By announcing the advent of a new gold standard well in advance, markets would have a chance to get used to the idea and its implications. Right now the price of gold reflects a significant amount of uncertainty and fear of higher inflation. If a new gold standard were done right, the gold price would likely decline significantly before being pegged, because these uncertainties would be eliminated. My guess is that the price would be closer to $500/oz., the average real price of gold over the last century, than to its current price.

The aftermath of the housing bubble looks good for equities

Back in the early 1980s, when I was working for him at Claremont Economics Institute, John Rutledge came up with a version of this chart. He used it to argue that relative prices of things can and do change as inflation fundamentals change. With inflation soaring throughout the 1970s, households responded by attempting to increase their holdings of tangible assets. That's a rational response, since tangible assets tend to hold their value during periods of inflation, whereas financial assets (especially bonds) tend to lose their value. The attempt by households to increase their tangible asset exposure was most noticeable in the real estate market, and it resulted in a sharp rise in housing prices relative to the prices of financial assets (indeed, bond prices collapsed and stock prices went sideways). When inflation began to fall in the early 1980s, he argued that households would reverse their earlier plunge into real estate, with the result that financial asset prices would experience a boom. And he was right.

In updating his chart, I'm struck by how the surge in real estate prices in the early 2000s was not accompanied by rising inflation. It was a bubble that was inflated not by the desire to acquire inflation protection, as happened during the 1970s, but by other factors, such as the invention of mortgages that required little or no down payment or documentation, and creative financing options like interest-only or negative-am loans. It was a massive leveraging-up spree that inflated the housing bubble.

The chart now suggests that housing prices have come back down to earth, and are consistent with the relatively low and stable inflation of the past two decades. In the process of coming back down to earth, the sudden collapse of the housing market and the ensuing financial panic of late 2008 sent households scurrying for the shelter of savings deposits (up over $2 trillion in the past three years), and for the relative safety of bonds—everyone wanted to deleverage and de-risk. That phase is winding down now, however, and the next phase is underway. As households regain confidence in the economy, they are beginning to attempt to shift the money socked away in savings accounts and bonds into both housing (which has become incredibly cheap given the plunge in financing costs) and equities. That's why we're likely to see rising housing prices, rising equity prices, and falling Treasury bond prices in coming years. A shift in households' desired portfolio holdings could create more than enough demand to absorb all the foreclosed houses that banks may end up dumping on the market.

It's not that all the cash on the sidelines goes into the equity market, it's that the desire of households and investors to shift the composition of their portfolios causes a change in relative prices. If the urge to reduce cash holdings is strong enough, and if the Fed doesn't act to offset the decline in the demand for money (by raising rates) this process could fuel a rise in a wide range of prices, and this could show up as higher inflation.

Ongoing improvement in the jobs market

The three-year downward trend in seasonally adjusted unemployment claims continues, as shown in the top chart. New claims for unemployment are down more than 10% from the same period last year, and relative to the size of the labor force, claims today are lower than at any time prior to 1997. As the bottom chart shows, the number of people receiving unemployment insurance continues to fall as well: there are 15% fewer people "on the dole" today than at this same time last year. The number receiving "emergency" claims has fallen by more than half (over 3 million people) since the high of early 2010. There is undeniable progress being made on all fronts.

As the pace of layoffs approaches levels that are about as low as they are likely to get, it is very difficult to believe that the pace of hirings won't continue to increase.

And with no sign whatsoever of any increase in claims or any deterioration in the jobs market, it is also very difficult to believe that the economy is on the verge of another recession.

Should another recession happen, however, it would almost surely be very mild, because employers have done just about all the cost-cutting they need to do. The economy has spent the past three years adjusting to a huge oversupply of housing and a big increase in energy prices, by shifting resources massively away from residential construction and into new areas such as the booming oil and gas industry. What other shocks might we have to adjust to? Shocks always come out of the blue, so it's hard to rule them out at this point, but we've all been subject to shocks of one kind or another in the past four years, and markets are still priced to grim conditions, as evidenced by today's 2.3% 10-yr Treasury yield, and below-average PE ratios despite record-high corporate profits. When you're braced for the worst, it's easy to deal with minor setbacks. In short, I think the economy is far more likely to continue to improve than it is to suffer renewed deterioration.

Anecdotally, I'm hearing that mortgage originators have seen a big increase in new applications in the past week or so, which if true, is likely a response to the recent uptick in the 10-yr Treasury yield. A "buy now before mortgage rates go higher" mentality may have been triggered. I'm also seeing scattered reports that housing prices in several areas of the country appear to be on the rise.

Heard on the beach today

Why higher interest rates are not bad news

10-yr Treasury yields (top chart) hit bottom last September (1.72%), and are now 66 bps higher (2.38%). Conforming 30-yr fixed mortgage rates hit bottom last December (3.94%) and are only marginally higher today (4.09%). There's a bit of a lag between the two, and the spread between 10-yr Treasuries and Fannie Mae collateral has compressed to about as tight as it's going to get. So the recent rise in 10-yr Treasury yields will almost surely result in a significant increase in conforming mortgage rates in the weeks and months to come. If the recent rise in Treasury yields holds, then the bottom chart is depicting what will prove to be the all-time low in mortgage rates.

If mortgage rates are headed higher, won't this slow or possibly halt the nascent housing market recovery? No, and here's why:

To begin with, Treasury yields and mortgage rates fell to historically low levels last fall primarily because a) the demand for safe-haven Treasuries and agency mortgages was intense, since the market fully expected the U.S. economy to fall into another recession, and b) the demand for home mortgages was historically weak, because potential homebuyers were fearful that prices would decline further. In short, the intense demand for safe-haven Treasuries and relatively safe mortgages coupled with the very weak demand for home mortgages resulted in a surfeit of loanable funds which, in turn, pushed interest rates to historically low levels.

Today's rising interest rates signal an important reversal in investor psychology and in the prospective health of the economy. Things are getting better, and the demand for safe-haven Treasuries is therefore declining. An improving economy should bolster the demand for mortgages, even as interest rates rise. Rising interest rates go hand in hand with an improving economy; higher interest rates don't weaken the economy, because they are a direct reflection of a stronger economy. Higher rates only become a threat to the economy when they are driven higher by tight monetary policy, but that is manifestly not the case today. Moreover, prospective homebuyers are likely to be encouraged to buy even as rates rise, because they will begin to see that it is better to buy now than to wait for rates to rise even more. At today's prices and even with substantially higher interest rates, housing is more affordable than ever before for the majority of households.

This chart comes from the National Assoc. of Realtors, and shows that a family earning the median income has about twice the amount needed to purchase a median-price home using conventional financing.

A Eurozone recovery is in sight

This chart of U.S. and Eurozone industrial production shows the huge divergence in economic activity that has opened up in the past several months between the U.S. and Europe. From the looks of this chart, the Eurozone economy has probably been in the grips of a modest recession since last September, no doubt sparked by the financial turmoil created by the Eurozone sovereign debt crisis. 

In any case, the behavior of swap spreads—a reliable indicator of systemic risk and a good leading indicator of economic behavior—suggests that the financial strains which have slowed the Eurozone economy have diminished significantly this year. That points to a Eurozone recovery that should be getting underway soon, if not already.

The first of the above two charts tracks German business confidence, and it is noteworthy that it has turned up in the first two months of this year after a sharp contraction which paralleled the decline in Eurozone industrial production. The second chart measures German Industrial Production, and here too we see emerging signs of what could prove to be a bottom.

Finally, I note that the Euro Stoxx Index has turned up, albeit quite modestly. Stocks typically are able to sniff out recoveries before they officially happen (e.g., the U.S. equity market turned up about 3 months prior to the mid-2009 recovery started), and there's no reason to think that isn't the case today. The Eurozone recovery is likely to be a modest one, however, because Europe is still burdened by excessive government spending. Nevertheless, progress is being made, and simply halting the growth in spending ought to be enough to improve sentiment and, in turn, growth.

Housing recovery still intact

February housing starts declined a bit, but the larger picture is that the housing recovery remains very much intact. Starts are up 35% over the past 12 months, and up 46% from their recession low. Starts of course still very low from an historical perspective, but they are improving and that is a very good sign that the residential real estate market has hit bottom, thanks to the combination of market-clearing low prices and low interest rates.

Mountains of cash are still on the sidelines

As a follow-up to this morning's post, here are some charts that survey the state of liquidity in the U.S. economy. It's unambiguously the case that the public is still desperate for the safety of cash and cash equivalents, and risk-aversion (e.g., a preference for bonds over stocks) is still very high. Liquidity is in abundant supply; the Fed has supplied trillions of cash to a dollar-cash-hungry market; bank loans are expanding; consumer credit is expanding; savings deposits in U.S. banks are still increasing at double-digit rates. Taxable bond funds continue to receive $5-6 billion in net inflows every week, while equity funds are still experiencing net outflows.

Banks are definitely lending again. In fact, lending has been increasing since October 2010. Commercial & Industrial Loans (i.e., bank lending to small and medium-sized businesses) are up $170 billion, and they are up at a robust 15.8% annualized pace over the past three months. Consumer Credit (second chart above) is experiencing a similar increase, up by $240 billion, for an annualized rate of increase of 9% in the three months ending January 2012.

M2 is growing above its long-term average annual rate of 6%, even though the economy is 12-13% below its long-term trend. Strong demand for money is the explanation, with a lot of that dollar demand likely coming from the Eurozone. Money demand is likely to begin to decline going forward, however, now that the Eurozone crisis is beginning to fade.

By far the biggest source of growth in M2 is savings deposits. These have increased by over $2 trillion since late 2008, and have grown at a blistering 15.7% annualized pace over the past three months. This is unusually strong growth that can only reflect great fear and caution on the part of investors everywhere, especially when one considers that savings deposits pay virtually no interest.

According to ICI, taxable bond funds in recent months (through February '12) have experienced strong net inflows, while domestic equity funds have experienced net outflows. No sign here of any unusual enthusiasm for stocks on the part of investors. Indeed, the strong preference for bond funds reflects unusual caution.

This all adds up to a pretty clear picture of a market that continues to be dominated by caution and a strong preference for cash, cash equivalents, and relatively "safe" assets such as bonds. Should the strong performance of equities, the continued signs of economic growth, and the recent sharp selloff in Treasuries manage to change investors' preferences, the consequences could be difficult to imagine given how much cash is parked on the sidelines.

The equity rally has legs

The equity rally that began almost six months ago has legs, since it's being driven by improving economic and financial fundamentals, and the rise in Treasury yields is a key indication that this is the case. Yields had been (and remain) severely depressed because global investors had almost no hope that the U.S. economy would improve or that the world would avoid another painful recession. Instead, we see a steady stream of better-than-expected economic reports suggesting the U.S. economy is slowly improving. This forces investors to reconsider their love of Treasuries and their aversion to equities. In that sense, this is a rally driven not by optimism but by reduced pessimism. Treasury yields would need to be much higher before I would consider the market to be driven by optimism.

This chart shows how the improvement in Eurozone banks' ability to acquire dollar funding (as represented in a declining blue line) has led the reduction in Eurozone swap spreads, which in turn is a good indication of improved general liquidity conditions and reduced systemic risk. When financial markets are liquid they can and do function as shock absorbers for the physical economy, because they allow market participants to shift the burden of risk to stronger players. Spreading the burden of risk, in turn, facilitates economic growth, and growth is the best remedy for the problems that still plague Europe.

Financial conditions in the U.S. have returned to "normal" and Eurozone financial conditions have improved significantly, although they remain somewhat precarious. Europe needs more convincing structural reforms (e.g., lower tax burdens and a reduction in the size of the public sector) before the outlook can turn positive.

This chart shows the market's 5-year, 5-year forward inflation rate, a good measure of near-term inflation expectations. Note that expected inflation has increased by half a point since last October, from 2.0% to 2.6%. I take this to be an indication of how, on the margin, the market has become less concerned with the threat of deflation, and more concerned with the risk that the Fed's ultra-accommodative monetary policy may be exacerbating inflation risks.

Consumer price inflation still moderate

Inflation according to the CPI remains moderate: no surprises. As the chart above shows, inflation is running in the 2-3% range, regardless of whether or not you include the contribution of energy prices. This level of inflation is very close to what we have seen over the past decade. For reference, on an annualized basis, the CPI is up 2.5% over the past two years; 2.4% over the past three years; 2.3% over the past 5 years; and 2.5% over the past 10 years.

There is nothing alarming about this level of inflation in any sense. No sign of a big inflation increase, and no threat of deflation either. The Fed has absolutely no need to engage in any further quantitative easing or easing of any variety. The Fed's next move will likely be to increase rates, but the timing of that move is unfortunately still shrouded in mystery. Recent action in the bond market (e.g., a 20 bps rise in 2-yr Treasury yields, and a 40 bps rise in 5-yr yields) suggests that the Fed will begin tightening sooner than was expected just a few months ago. I think it's reasonable to assume that we will see more of this action in the months to come.

Manufacturing production is very strong

February industrial production was unchanged from January, but this masks the fact that January production was revised up by 0.4% and February's weakness was concentrated in utilities and mining. Manufacturing production is where the strength lies, and this is shown in the charts above. Over the past six months, manufacturing production is up at a strong, 7.4% annualized rate. US factories are simply churning out a lot of stuff, and there is no sign at all of weakness on this score.

TIPS update--not very attractive

The top chart shows the nominal yield on 10-yr Treasuries, the real yield on 10-yr TIPS, and the difference between the two, which is the market's expected average annual inflation rate over the next 10 years. The bottom chart focuses on the real yield on 10-yr TIPS, and overlays my estimate of how intrinsically valuable TIPS happen to be at different levels of real yields. The lower the real yield, the less intrinsically valuable TIPS are, because TIPS are a unique asset since they pay a government-guaranteed real yield—nothing else can make that claim. (TIPS are Treasury bonds whose principal is adjusted by the CPI, and whose coupon is therefore a real yield.) TIPS are very expensive today because they actually have a negative real yield. TIPS would be attractive relative to Treasuries if inflation proves to be higher than expected, but with a guaranteed real yield that is negative, TIPS are not necessarily attractive at all in an absolute sense.

The long-term story told in the top chart is that ever since TIPS were first issued in 1997, nominal and real yields have been in decline, but the difference between the two hasn't changed much on balance. Inflation expectations have moved up and down, but current inflation expectations are not greatly different from the inflation we've actually experienced over the past decade: current inflation expectations are 2.38% for the next 10 years, while the CPI has averaged 2.48% over the past 10 years.

So the only thing that has really changed is real yields, which have declined from 3% to zero. The decline in real yields has brought with it a decline in nominal yields, since inflation expectations haven't changed much. I think real yields have declined mainly because the economy has run out of gas, and that has depressed the market's expectations for real returns across a variety of assets. Think of TIPS as defining the zero-risk real rate of return for various maturities of assets in real, inflation-adjusted space. 10-yr TIPS today are saying that if you want to lock up your money for 10 years with no possibility of default, then you must accept a slightly negative real rate of return. All other long-term assets offer a higher expected real return, along with the risk of principal loss. Put another way, 10-yr TIPS are telling us that the market believes that other, risky assets on balance don't have the potential to deliver much more than, say, a 1% real rate of return or slightly better. The expected real return of all assets has declined along with the decline in TIPS real yields, and that can only mean that the market does not expect much real growth from the U.S. economy. In short, the real yield on TIPS is inextricably linked to the market's expectations for economic growth.

The economy's poor performance in recent years is directly reflected in the growing gap between real GDP growth and its 3% long-term growth trend, which has widened since 2006, when real yields were about 2.5%. The Fed, via its quantitative easing policies and its "operation twist," has encouraged nominal yields to fall, in the hopes that lower long-term yields would help spark stronger growth. But since monetary policy cannot create growth out of thin air, the Fed's efforts cannot raise growth expectations, and they cannot—by extension—push real yields higher. If anything, aggressive monetary ease likely reduces growth expectations, since easy money increases the incentives to speculative (i.e., non-productive) activities.

If the economy starts to pick up—exceeding the current dismal expectations of market participants—and the GDP gap starts to narrow, then we should see higher nominal yields, because the market will begin (as it has in recent days) to ratchet higher its expectations for Fed tightening. Real yields are likely to rise as well as economic growth expectations improve. If inflation expectations increase alongside a pickup in growth expectations, then the rise in nominal yields should exceed the rise in real yields.

The price of TIPS is thus quite vulnerable to any unexpected strengthening of the U.S. economy, regardless of whether inflation proves higher than expected or not. A TIPS investor would benefit directly from higher inflation, but at the same time suffer a decline in the value of TIPS. So TIPS are not a very "clean" or cheap inflation hedge, since the gains from higher inflation would likely be eroded by the loss from higher real yields.

To sum up: TIPS are only attractive to an investor who believes 1) that inflation will prove to be higher than expected, and 2) that economic growth will continue to be disappointing.